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Monday, March 3, 2008

An Isreali Dutch Disease

Stanley Fischer is a different kind of Bank of Israel governor. His worldview does not resemble that of his two predecessors, Jacob Frenkel and David Klein. While his goal, too, is price stability, he also takes growth and employment into consideration.

For Klein and Frenkel, price stability was the only goal. They used to say that the Bank of Israel has only one tool, that of interest rates, with which only one issue can be addressed: inflation. It should be remembered that they held their posts during a more difficult period, when a strict monetary policy was needed to bring down inflation. That approach is suitable for the European Central Bank, which also sees its only purpose as dealing with inflation.

But Fischer was educated in the United States, where the approach is different. There, the head of the Federal Reserve (parallel to Israel's central bank governor), weighs the state of inflation as well as growth and employment trends. That is how legendary Fed chief Alan Greenspan acted in lowering interest rates sharply after the attack on the World Trade Center in 2001. He left it very low (1 percent) for a long time to fight the danger of the American economy sliding into a recession.

The current Federal Reserve head, Ben Bernanke, did the same in January, sharply lowering U.S. interest rates by 1.25 percent to a low 3 percent - to fight the unfolding economic slowdown.

Let there be no confusion: Fischer's primary goal is still price stability. But the moment interest rates can be lowered without compromising stability too greatly - he will do it.

Fischer should have actually lowered interest rates a month ago. It was a mistake to leave the February rate at 4.25 percent. Even then it was clear that inflation is declining and the world economy is slackening. In a meeting at that time one senior director voted to lower rates, but the majority was against it. Thus the reduction was put off until March, and will only go into effect today.

Fischer decided to lower rates in one fell swoop by half a percent because he did not want to do it piecemeal; that would only cause unnecessary pain. Many were surprised at the news, but Fischer knows that Bernanke will lower interest rates again on March 18 by another half a percent and he does not want to widen the gap with U.S. rates.

The governor also knows that the forces working against inflation have grown stronger in recent weeks. There are signs of recession in the U.S., as well as in Europe and Japan, which will slow growth and lower inflation in Israel.

The weakening of the dollar and the euro since mid-December has lessened economic pressures. It is also reasonable to assume that the actions and pressure by Shraga Brosh, president of the Manufacturers Association, to lower interest rates also had their effect on the governor and his people.

Nevertheless, interest rates are an instrument that is limited in its effect. Real factors have a greater impact. The economy is still growing, exports are flourishing and the balance of payments is in the black. A steady stream of foreign investments and unilateral transfers also continues. All this means a surplus of foreign currency, leading to a weakening of the dollar and the euro.

We seem to be suffering from "Dutch disease." This is what happened to Holland in the 1960s when large reserves of natural gas were discovered offshore. After the discovery, Dutch exports increased and the local currency grew stronger. This damaged the country's traditional export industries, which is what is happening to us.

But we have no natural gas. We have high tech and the Internet, which are our natural resources. They have buoyed exports in recent years, leading to a surplus in the balance of payments.

Therefore, a major devaluation will not be the outcome of a small change in interest rates, but rather the outbreak of a third intifada or a missile from Tehran landing in the middle of Tel Aviv. If that happens, the flow of capital to Israel will cease, exports will suffer, and the exchange rate will soar back toward NIS 5 to the dollar.